Time to change the way we think about the world

China should start exporting more goods than the USA in late 2005/ early 2006. That is rather impressive. It means that China is now too big not to play a bigger role in the management of the world economy -- and to take more responsibilty for the constructive resolution of global imbalances.

Almost everyone forecasted some slowdown in China's export growth in 2005. It certainly makes sense - sustaining 30% plus y/y growth is really hard. But those forecasts no longer look very plausible.

In August, China's exports were up 32.1% over August 2004. Imports were up 23.4% over last August as well - in part because of higher oil prices. There is no real sign China's export growth is slowing. So far, Chinese exports are winning battle between growing Chinese productive capacity and slower global growth in demand for all goods, as oil eats up an ever growing share of consumers' income. The political backlash against China's export growth is building, but it has yet to bite.

Setting politics aside, right now, it easier to identify economic forces that might lead Chinese import demand to slip back from its August pace than forces that will lead Chinese export growth will slow. Throughout this year, the expansion of China's productive capacity has led China to substitute domestic content for imported content. Rising oil prices right now are serving to mask the impact of that process, but once oil prices stabilize, Chinese import growth might slow.

Consequently, I thought it would be interesting to forecast out China's 2005 exports and imports on the assumption that the August rates of growth in imports and exports are sustained for the second half of the year. The numbers: 2005 exports would reach $790 billion (33% annual growth) and 2005 imports would reach $668 billion (19%) annual growth. China's trade surplus would reach $122 billion

For y/y export growth to fall to 25% -- as many have predicted - second half export growth would need to fall to around 18%. The World Bank forecasts growth of only 23%, the ADB forecasts growth of 20.4%. The IMF is a bit better -- it forecasts export growth of 26.5% (y/y). But even that forecast implies second half growth of around 20%, which now seems unlikely. A side note -- the IMF's 2004 import numbers seem off to me ... most sources have 2004 imports of around $561 billion, v $535 in the IMF data release. See the ADB statistics.

A Chinese trade surplus of $122 billion implies a current account surplus of around $140 billion - or roughly 7.5% of Chinese GDP. In other words, China's current account surplus looks to be the mirror image of the US current account deficit.

That is why I found the IMF's unwillingness to go beyond indicating that China needs more "exchange rate flexibility" disappointing. Global rebalancing - at least orderly rebalancing -- implies adjustment by both surplus and debtor countries. China has to do its part. The IMF needs to do more than congratulate itself for: " tak[ing] the lead in calling for concerted action to address global current account imbalances." It has to be willing to signal clearly that addressing global imbalances requires confronting difficult issues -- the level of the RMB and excessive savings in China as well as the pace of domestic demand growth and low levels of the savings in the US-- head on.

Now in practice, I suspect any move toward "flexibility" - say widening the band around China's current de facto peg - will lead the RMB to appreciate, so there may not be much difference between "flexibility" and a "step revaluation" in practice. And as I have argued earlier, so long as the RMB crowds the upper end of any band and the market expects it would rise further but for central bank intervention, the Chinese central bank's monetary policy flexibility will still be constrained.

But the IMF's unwillingness to signal more forcefully that global rebalancing requires RMB revaluation will - I think - limit the IMF's ability to help bring about orderly global rebalancing. If the IMF cannot signal that a country with a 7% of GDP plus current account surplus, substantial FDI inflows, reserve growth of 15% of GDP and 30% y/y export growth rate has an undervalued exchange rate, it will never be able to signal that any country has an undervalued exchange rate. To be fair, the IMF's research department -- as has often been the case -- is a bit more willingness to send the needed signals than the rest of the institution. Laxton and Milesi-Ferretti indicate fairly clearly in their WEO analytical chapter that emerging Asian currencies need to appreciate.

Global rebalancing also requires other kinds of policy action as well. Steps by China to stimulate consumption demand (more consumption spending by the government might be a good start). Stronger domestic demand growth in Germany and the rest of Europe would help, though the policy steps needed to spur German consumption (and housing prices) are not obvious to me - some labor market reforms might work in the opposite direction. And steps by the US to raise national savings, something most easily accomplished by reducing the federal government's budget deficit.

But RMB revaluation is an essential part of the equation. It is needed to send a signal to Chinese (and foreign) firms that they need to reduce their investment in China's export sector.

Mike Mussa - the IMF's former Chief Economist - delivers the kind of clear forthright signal I think the IMF should be sending, but is not. Mussa writes:

Maintenance of a substantially undervalued exchange rate for the yuan is part of the explanation for continued very strong export growth .... Conceivably the government could put resources toward its stated goal of encouraging development of the interior of the country, but it will be difficult to achieve much success in this area when policy has to fight an uphill battle against an undervalued exchange rate, which significantly advantages development of the coastal regions. .... The point of political tolerance for a rising Chinese trade surplus with the US already has been reached, and the situation vis a vis Europe is not much better. The attitude of China's Asian trade partners will also become less friendly if Chinese exports continue to surge while its imports from the rest of Asia stagnate. One way or another, the Chinese government will find that it is not possible to achieve a further large increase in net exports to boost substantially domestic real output. (emphasis added)

I tend to agree. President Hu indicated that China intends to import more from the US -- which is a step in the right direction. But given than China exports over five times as much to the US as imports, it is unrealistic to think US exports to China will ever be able to grow fast enough to offset current rates of import growth.I hope China's government realizes that it is not in its interest any more than it is in the United States long-term interest for the necessary slowdown in China's export growth to come from a political confrontation with the US rather than from preemptive action by the government of China to bring China's exchange rate closer to a realistic value.